Media Briefings

‘ANIMAL SPIRITS’: How the stock market drives unemployment – and what to do about it

  • Published Date: May 2013

The stock market and the unemployment rate are like two drunks walking down the street tied together with a rope, according to Professor Roger Farmer, currently a senior visiting fellow at the Bank of England. They can move apart for short periods of time, he says, but eventually they must move together. The key question is, which one moves the other?

Professor Farmer’s analysis of the data shows that the stock market marches to its own tune and, six months later, it drags the unemployment rate along with it. It is this fact that leads him to advocate a policy of active financial market stabilisation to restore full employment and get the economy back to a path of sustainable growth.

In recent testimony to the UK Treasury Select Committee (23 April 2013), Professor Farmer argued for the creation of a sovereign wealth fund that would be used to stabilise inefficient fluctuations in the stock market. Writing in the May 2013 issue of the Economic Journal, he explains why this would tackle the problems of low growth and high unemployment that western economies are still facing, five years after the onset of the financial crisis.

Professor Farmer’s study provides a new paradigm for macroeconomics that reconciles asset price bubbles with rational behaviour by households and firms. In his work, individuals are rational but markets are not, a fact that has important implications for government policy.

He revisits two important ideas from Keynes’ General Theory. The first is that high unemployment can persist forever as one of many possible equilibrium outcomes of a market economy. The second is that the unemployment rate that prevails is determined by the ‘animal spirits’ of market participants.

The idea of involuntary unemployment as an equilibrium was central to Keynes but was discarded in the 1950s by his followers. According to the consensus that evolved between Keynesian and monetarist theorists in the post-war period, high unemployment persists because wages and prices are sticky. Joan Robinson, an eminent Cambridge economist and a contemporary of Keynes, referred to this betrayal of Keynesian economics as ‘bastard Keynesianism’.

Professor Farmer discards the post-war consensus and provides an alternative way of reconciling Keynesian economics with classical ideas. His new paradigm explains why unemployment persists by providing a theory of unemployment based on search frictions in the labour market.

He explains why the economy moves between cycles of boom and bust by modelling the animal spirits of investors as a fundamental of the theory, which is determined by individual psychology. The animal spirits of investors select which unemployment rate will prevail.

The theory described in the new study is supported by empirical work, published in 2012, in which Professor Farmer shows that unemployment and the stock market move in tandem. In technical terms, they are ‘cointegrated random walks’.


Notes for editors: ‘Animal Spirits, Financial Crises and Persistent Unemployment’ by Roger Farmer is published in the May 2013 issue of the Economic Journal.

Roger Farmer is currently Senior Houblon Norman Fellow at the Bank of England and Distinguished Professor of Economics at the University of California, Los Angeles.

For further information: contact Roger Farmer via email:; or Romesh Vaitilingam on +44-7768-661095 (email:; Twitter: @econromesh).